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CHAPTER 1 TEN PRINCIPLES OF ECONOMICS


2007 Thomson South-Western, all rights reservedN. G R E G O R Y M A N K I WPowerPoint Slidesby Ron Cronovich

1Ten Principles of Economics


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSIn this chapter, look for the answers to these questions:What kinds of questions does economics address?What are the principles of how people make decisions? What are the principles of how people interact?What are the principles of how the economy as a whole works?


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSWhat Economics Is All AboutScarcity refers to the limited nature of societys resources.Economics is the study of how society manages its scarce resources, includinghow people decide how much to work, save, and spend, and what to buyhow firms decide how much to produce, how many workers to hirehow society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs0


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE MAKE DECISIONSDecision making is at the heart of economics. The first four principles deal with how people make decisions. 0


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE MAKE DECISIONSAll decisions involve tradeoffs. Examples:Going to a party the night before your midterm leaves less time for studying.Having more money to buy stuff requires working longer hours, which leaves less time for leisure.Protecting the environment requires resources that might otherwise be used to produce consumer goods.Principle #1: People Face Tradeoffs0


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE MAKE DECISIONSSociety faces an important tradeoff: efficiency vs. equity efficiency: getting the most out of scarce resourcesequity: distributing prosperity fairly among societys membersTradeoff: To increase equity, can redistribute income from the well-off to the poor. But this reduces the incentive to work and produce, and shrinks the size of the economic pie. Principle #1: People Face Tradeoffs0


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE MAKE DECISIONSMaking decisions requires comparing the costs and benefits of alternative choices. The opportunity cost of any item is whatever must be given up to obtain it. It is the relevant cost for decision making.

Principle #2: The Cost of Something Is What You Give Up to Get It


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE MAKE DECISIONSExamples: The opportunity cost ofgoing to college for a year is not just the tuition, books, and fees, but also the foregone wages. seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater. Principle #2: The Cost of Something Is What You Give Up to Get It


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE MAKE DECISIONSA person is rational if she systematically and purposefully does the best she can to achieve her objectives.Many decisions are not all or nothing, but involve marginal changes incremental adjustments to an existing plan.Evaluating the costs and benefits of marginal changes is an important part of decision making.Principle #3: Rational People Think at the Margin


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE MAKE DECISIONSExamples:A student considers whether to go to college for an additional year, comparing the fees & foregone wages to the extra income he could earn with an extra year of education.A firm considers whether to increase output, comparing the cost of the needed labor and materials to the extra revenue. Principle #3: Rational People Think at the Margin


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE MAKE DECISIONSincentive: something that induces a person to act, i.e. the prospect of a reward or punishment. Rational people respond to incentives because they make decisions by comparing costs and benefits. Examples:In response to higher gas prices, sales of hybrid cars (e.g., Toyota Prius) rise.In response to higher cigarette taxes, teen smoking falls. Principle #4: People Respond to Incentives


A C T I V E L E A R N I N G 1: ExerciseYou are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car as is. In each of the following scenarios, should you have the transmission repaired?A.Blue book value is $6500 if transmission works, $5700 if it doesntB.Blue book value is $6000 if transmission works, $5500 if it doesnt*


A C T I V E L E A R N I N G 1: AnswersCost of fixing transmission = $600A.Blue book value is $6500 if transmission works, $5700 if it doesntBenefit of fixing the transmission = $800 ($6500 5700). Its worthwhile to have the transmission fixed. B.Blue book value is $6000 if transmission works, $5500 if it doesntBenefit of fixing the transmission is only $500.Paying $600 to fix transmission is not worthwhile.*


A C T I V E L E A R N I N G 1: AnswersObservations:The $1000 you previously spent on repairs is irrelevant. What matters is the cost and benefit of the marginal repair (the transmission). The change in incentives from scenario A to scenario B caused your decision to change. *


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE INTERACTAn economy is just a group of people interacting with each other. The next three principles deal with how people interact.0


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE INTERACTRather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods. Countries also benefit from trade & specialization:get a better price abroad for goods they producebuy other goods more cheaply from abroad than could be produced at homePrinciple #5: Trade Can Make Everyone Better Off


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE INTERACTA market is a group of buyers and sellers. (They need not be in a single location.)Organize economic activity means determining what goods to produce how to produce them how much of each to producewho gets themPrinciple #6: Markets Are Usually A Good Way to Organize Economic Activity


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE INTERACTIn a market economy, these decisions result from the interactions of many households and firms. Famous insight by Adam Smith in The Wealth of Nations (1776): Each of these households and firms acts as if led by an invisible hand to promote general economic well-being. Principle #6: Markets Are Usually A Good Way to Organize Economic Activity


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE INTERACTThe invisible hand works through the price system:The interaction of buyers and sellers determines prices of goods and services. Each price reflects the goods value to buyers and the cost of producing the good. Prices guide self-interested households and firms to make decisions that, in many cases, maximize societys economic well-being. Principle #6: Markets Are Usually A Good Way to Organize Economic Activity


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE INTERACTImportant role for govt: enforce property rights (with police, courts)People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen. A restaurant wont serve meals if customers do not pay before they leave. A music company wont produce CDs if too many people avoid paying by making illegal copies.Principle #7: Governments Can Sometimes Improve Market Outcomes


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE INTERACTGovt may alter market outcome to promote efficiencymarket failure, when the market fails to allocate societys resources efficiently. Causes:externalities, when the production or consumption of a good affects bystanders (e.g. pollution)market power, a single buyer or seller has substantial influence on market price (e.g. monopoly)In such cases, public policy may increase efficiency. Principle #7: Governments Can Sometimes Improve Market Outcomes


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW PEOPLE INTERACTGovt may alter market outcome to promote equityIf the markets distribution of economic well-being is not desirable, tax or welfare policies can change how the economic pie is divided. Principle #7: Governments Can Sometimes Improve Market Outcomes


A C T I V E L E A R N I N G 2: Discussion QuestionsIn each of the following situations, what is the governments role? Does the governments intervention improve the outcome?a.Public schools for populationb.Workplace safety regulationsc.Public highwaysd.Patent laws, which allow drug companies to charge high prices for life-saving drugs*


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW THE ECONOMY AS A WHOLE WORKSThe last three principles deal with the economy as a whole. 0


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW THE ECONOMY AS A WHOLE WORKSHuge variation in living standards across countries and over time:Average income in rich countries is more than ten times average income in poor countries. The U.S. standard of living today is about eight times larger than 100 years ago.Principle #8: A countrys standard of living depends on its ability to produce goods & services.


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW THE ECONOMY AS A WHOLE WORKSThe most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor. Productivity depends on the equipment, skills, and technology available to workers.Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards.Principle #8: A countrys standard of living depends on its ability to produce goods & services.


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW THE ECONOMY AS A WHOLE WORKSInflation: increases in the general level of prices. In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall. The faster the govt creates money, the greater the inflation rate. Principle #9: Prices rise when the government prints too much money.


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSHOW THE ECONOMY AS A WHOLE WORKSIn the short-run (1 2 years), many economic policies push inflation and unemployment in opposite directions. Other factors can make this tradeoff more or less favorable, but the tradeoff is always present. Principle #10: Society faces a short-run tradeoff between inflation and unemployment


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSCONCLUSIONEconomics offers many insights about the behavior of people, markets, and economies. It is based on a few ideas that can be applied in many situations. Whenever we refer back to one of the Ten Principles from this chapter, you will see an icon like this one:


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSCHAPTER SUMMARYThe principles of decision making are:People face tradeoffs.The cost of any action is measured in terms of foregone opportunities. Rational people make decisions by comparing marginal costs and marginal benefits.People respond to incentives.


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSCHAPTER SUMMARYThe principles of interactions among people are:Trade can be mutually beneficial.Markets are usually a good way of coordinating trade. Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable.


CHAPTER 1 TEN PRINCIPLES OF ECONOMICSCHAPTER SUMMARYThe principles of the economy as a whole are:Productivity is the ultimate source of living standards. Money growth is the ultimate source of inflation. Society faces a short-run tradeoff between inflation and unemployment.


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